A leveraged ETF tracking MicroStrategy has plummeted 65% over the past 12 months, while the company's stock price has risen 28% during the same period. This stark contrast has brought the issue of "volatility decay" into sharp focus.

For investors eager to enhance returns during a record bull market, leveraged ETFs were once seen as a shortcut. As of mid-October, the asset size of leveraged single-stock ETFs has grown to approximately $40 billion.

However, the rapid expansion of these products is leading more investors to incur unexpected losses, particularly those who misunderstand how leveraged funds operate. According to Morningstar data, traders withdrew nearly $5 billion from leveraged single-stock funds over the past two quarters, marking the first outflow for this category.

Meanwhile, ETF issuer Volatility Shares last week filed documents to launch 27 high-leverage ETFs, including what may become the first 5X leveraged fund in the U.S. The SEC has previously opposed high-leverage funds, but due to a government shutdown halting the review of fund applications, these products may automatically be approved for issuance 75 days after filing.

How Leverage 'Erodes' Returns

The fundamental reason leveraged ETFs diverge in performance from their underlying assets over the long term lies in their “daily compounding” operating mechanism, which creates what traders call "volatility decay."

The most common type of leveraged ETF aims to achieve double the return of the underlying asset. For instance, a 2X leveraged ETF tracking Tesla would rise 10% on a day when Tesla’s stock increases by 5%. However, if Tesla falls by 5%, the ETF would drop 10%.

These funds are designed to provide a specific multiplier (e.g., 2X) of “daily” returns, not long-term returns.

For example, suppose a stock and its 2X leveraged ETF both begin at $10:

On Day 1, the stock declines 30% to $7, while the leveraged ETF falls 60% to $4. On Day 2, the stock rebounds strongly by 50%, rising to $10.5 for the week. However, for the leveraged ETF, even if it achieves a 100% increase (double the stock's 50% rise), its price can only recover from $4 to $8. By the week's end, it remains at a loss.

The greater the volatility of the stock, the more the long-term returns of the leveraged ETF become eroded. As ETF.com’s research director Dave Nadig states:

The more leverage or volatility you add to these funds, the more pronounced all their issues become.

Fund managers commonly warn that such products should not be held long-term.

Investors’ Painful Lessons: "Are We Done for?"

For many retail investors lured by the wealth stories circulating on social media and who have a limited understanding of the operational mechanisms, this mathematical trap has led to significant actual losses.

Two 2X leveraged ETFs tracking MicroStrategy serve as extreme examples, with their surges last year gaining attention on social media, drawing in a rush of thrill-seeking investors at an unprecedented rate.

Now, despite the underlying stock rising, many investors face substantial losses. On the Reddit investment forum, a user desperately posted:

"Are we holders of MSTU and MSTX (the codes for the two MicroStrategy leveraged ETFs) done for?"

Another investor discussing these funds wrote:

"If I didn’t understand price decay before, I do now. I've learned my lesson and don’t plan to touch leveraged ETFs again."

High Fees Drive Supply Surge

Despite large asset management firms like BlackRock and JP Morgan Asset Management avoiding such ETFs for risk reasons, many other institutions are drawn in by the hefty management fees.

Leveraged ETFs typically charge around a 1% asset management fee, significantly higher than the average rate of 0.3% for actively managed funds.

According to analysts at Bank of America, approximately 200 leveraged stock ETFs have launched in 2025 alone, bringing the total to 701 by October. As of mid-October, the asset size of single-stock leveraged ETFs has reached about $40 billion.

Money management firms have not been deterred by investors’ losses. Some institutions continue to roll out leveraged ETFs, seeking to profit from investors encouraged by the recent market rally. If regulators do not act within the 75-day application period, extreme products, including the first 5X leveraged fund, may be approved for issuance. Analysts note that such funds could become worthless and be liquidated if the underlying stock falls 20% in a single day.